Summary

Sitoy Group Holdings Limited (Sitoy) is engaged in developing and manufacturing of handbags, small leather goods, and travel goods on behalf of high-end luxury brands, such as Coach, Fossil, Michael Kors, Lacoste and Prada, and high-end travel brands, such as Tumi.

In Feb 2011, Sitoy introduced TUSCAN`S brand of handbags and small leather goods, a high-end fashion brand with Italian origins, and opened two retail stores in Guangzhou, China in February and March 2011. As of 31 October 2011, TUSCAN`S maintained seven stand-alone retail stores and nine department stores in China.

We forecast the leading P/E of Sitoy to be 10.4x and EPS of HKD$0.304. The offering price of HK$2.95 – 3.95 and an implied leading P/E of 9.7x to 12.99x represent a 7.22% upward potential to a 19.94% downside potential. We believe Sitoy is fairly priced with limited upside potential. However, investor should keep an eye on the improving market sentiment on IPO. If Sitoy recorded an over-subscription of 10x or more, we recommend investors to subscribe with margin financing. We initiate our coverage on Sitoy with a 12-month target price of HK$3.16 with a “Speculative subscription” rating.

Business Overview

Sitoy Group Holdings Limited (Sitoy) is engaged in developing and manufacturing of handbags, small leather goods, and travel goods on behalf of high-end luxury brands, such as Coach, Fossil, Michael Kors, Lacoste and Prada, and high-end travel brands, such as Tumi.

In February 2011, Sitoy introduced TUSCAN`S brand of handbags and small leather goods, a high-end fashion brand with Italian origins, and opened two retail stores in Guangzhou, China in February and March 2011. As of 31 October 2011, TUSCAN`S maintained seven stand-alone retail stores and nine department stores in China.

Sitoy is Coach (COH US) 's largest supplier of handbags with a 13-year business relationship. Revenues derived from Coach for FY 2009, 2010 and 2011 were HK$562.0 million, HK$908.4 million and HK$1,327.6 million, respectively, which constituted 41.6%, 52.6% and 53.2%, respectively, of revenue. Sitoy have not entered into long-term purchase agreements with any of its customers.

Manufacturing capacity and process

As of 31 October 2011, Sitoy operated five manufacturing facilities with 208 production lines, approximately 14,700 workers. Four of the manufacturing facilities are located in Dongguan China; and one is located in Yingde, China.

Sitoy manufactured and sold approximately 7.2, 9.0 and 12.3 million units with estimated annual production capacity of approximately 10.5 million, 12.8 million and 16.1 million units in FY 2009, 2010 and 2011 respectively. Estimated utilization rate for the corresponding Fiscal Years was approximately 69%, 73% and 76%. Sitoy's production lines increase from 123 to 191 from FY2009 – FY2011.

Current expansion plans include a second phase of expansion of manufacturing facility in Yingde. Production at the first two buildings of the second phase of the facility is expected to commence in or around December 2011. Production at the remaining buildings is expected to commence in 2013; 50% production capacity will be available at the beginning of FY 2013 and the remaining production capacity will be available at the end of 2013. The second phase will increase the number of production lines by 84 and the estimated annual production capacity by approximately 8.1 million units upon completion.

Sitoy maintained an in-house creative center and an R&D Center with approximately 1,100 and 62 staff. The in-house creative center is responsible for the production of prototypes from design concepts and sales samples, while the R&D Center did not directly involved in the design and development of products but was responsible for researching and implementing manufacturing technology.

Growth Driver

Robust revenue growth of Coach

As of July 2, 2011, Coach operated 322 retail stores and 138 factory stores in US, 23 retail stores and five factory stores in Canada, 169 department stores shop-in-shops, retail stores and factory stores in Japan and 66 department store shop-in-shops, retail stores and factory stores in Hong Kong, Macau and China.

The US is Coach major sources of revenue, contributed 70% of the total revenue; while Japan and other countries (primarily from East Asia, Hong Kong, Macau, China and Canada) accounted for 18% and 12% respectively. Total revenue growth rate came in 15.27% y/y in 2011. The other countries saw the strongest revenue growth of 45.51% y/y, while US and Japan grew 14.23% and 5.12% respectively.

During the sub-prime crisis in 2008 – 2009, Coach was able to achieve a modest growth of 1.56%, with US, Japan and other countries recorded of a growth rate of –2.7%, 10.67% and 25.70% respectively. It shows the resilience of Coach during crisis and we expected the same in future. Hence, we believe Sitoy's relationship with Coach will remain the major growth driver in future.

Proficient craftsmanship and sizable production scale

Sitoy has a proven track record of operations with international high-end and luxury brands, accumulated in-depth expertise and craftsmanship. The production process for a complex handbag involves over 200 steps, including the manual assembly of more than 100 separate components by skilled workers while only a limited number of steps can be automated.

In 2010, according to Frost & Sullivan, Sitoy had the largest global market share in terms of revenue at approximately 5% of the market for outsourced manufacturing of luxury handbags and small leather goods. We expected Sitoy 's market shares to increase further from 2010 – 2013 as the current expansion will increase Sitoy's production capacity by 8.1 million units or 50% comparing to FY2011.

Outsourced manufacturing of luxury handbags and small leather goods is classified as an O.E.M. industry. Thanks to its prolonged operational history and economies of scale in operation, Sitoy is currently the quality and cost leader and expected to maintain its leadership from short to medium term.

Solid profit margin

From FY2009 – 2011, we saw a remarkable improvement in Sitoy's gross profit margin and net profit margin; gross profit margin increased from 16.94% to 22.18% while net profit margin improved from 5.79% to 12.13%.

During the same period, Sitoy 's revenue spiked 85% while the COGS, S&D costs and administrative expenses increased 73.07%, 41.17% and 62.94% respectively, Hence, Sitoy was enjoying a better economies of scale in operation during expansion and we expected the profit margin to improve further upon the completion of the second phase of the Yingde plant.

However, we do not expect a significant growth in profit margin with the following reasons. 1. Further improvement in profit margin will attract potential competitors and drive the product prices down. 2. In FY2011, cost of raw materials accounted for 78.0% of total COGs. Prices of the raw materials, in particular leather, have risen in recent years and are likely to continue to increase for the foreseeable future. Although Sitoy will be able to transfer part of the increasing costs to its client, still, Sitoy has to bear the brunt of the increasing costs.

In future, we believe the retail business may become the major growth driver for profit margin. However, as the retail business is still under the development stage, it may take years for the retail business to start contribute.

Risk

- Sitoy has no experience in retail business. In addition, retail business in China possesses of great uncertainty. Focusing on the manufacturing business could be a better option for Sitoy.

- Raising labor costs in China may force international high-end and luxury brands to switch to other low cost production center such as Vietnam.

- The lack of intellectual Property laws and measures and the serious problems of counterfeit in China

Valuation

The fears of recession of the US economy and the Europe sovereign debt crisis are going to drag on and possibly become a financial catastrophe. Until now, there was no complete solution for the Europe sovereign debt crisis. Currently the O.E.M. industry of luxury good is trading near its historical average and with premium to Hang Seng Index. We believe it is due to the robust growth of the luxury good sectors in recent years. Investors should be aware of the deterioration of business environment and the substantial stock price adjustment of the industry during the financial turmoil.

For the valuation of the Sitoy, we adopted the financial multiplier valuation model with focus on P/E ratio. In our valuation, we take the following factors into consideration:

- Estimate sales turnover according to the expansion plan and products` price adjustment

- An upward adjustment in gross profit margin to reflect improved economies of scale of production

- An upward adjustment in administrative expenses to reflect the listing costs

- An upward adjustment in tax rate to reflect the one time tax reduction in FY2011

We forecast the leading P/E of Sitoy to be 10.4x and EPS of HKD$0.304. The offering price of HK$2.95 – 3.95 and an implied leading P/E of 9.7x to 12.99x represent a 7.22% upward potential to a 19.94% downside potential. We believe Sitoy is fairly priced with limited upside potential. However, investor should keep an eye on the improving market sentiment on IPO. If Sitoy recorded an over-subscription of 10x or more, we recommend investors to subscribe with margin financing. We initiate our coverage on Sitoy with a 12-month target price of HK$3.16 with a “Speculative subscription” rating.

Financial Data

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